By Beau Ruff

Should a person gift

the farm before death to avoid the complexity of probate and the estate tax?

Probably not.

The family farm

occupies a unique position in Washington state estate taxation. It is arguably

one of the best assets to own at death for a wealthy family. It has the benefit

of both protections from the estate tax while still garnering an income tax

boon with a tax basis step-up at death allowing the virtual income-tax-free

sale of property after death. This column digs into the concept a little

deeper.

First, a reminder on

the applicable estate taxes. For 2019, the federal government imposes an estate

tax on estates valued at more than $11.4 million, and Washington state imposes

the estate tax on estates valued at over $2.2 million. As is clearly evident,

the Washington estate tax hits many more people in Washington than the federal

estate tax.

One option to avoid

probate and the application of Washington’s estate tax is to gift property

before death. This is a common technique in estate planning, especially as it

relates to estate tax reduction. But, gifting would not likely maximize tax

benefits for the Washington farmer from an income tax point of view.

At

death, there is a little-known tax benefit that the federal government

provides. It is an adjustment to tax basis and it can have a profound effect on

the taxation of the assets owned at death. The tax code provides a boon for

individuals with capital assets (think stocks, land, buildings, real estate,

farms, etc.). That is, at death, the asset gets a new basis equal to its then

current fair market value. Take the example of a farm—if it is sold after

death, it gets a new tax basis equal to the then current fair market value.

Accordingly, when it is sold for that current fair market value, there is no

income-tax owing. This means that when sold at the then-current fair market

value, there will be zero income tax assessed on the sale of the capital asset

after death. Conversely, if the property is gifted prior to death, it receives

no such tax basis step-up and a sale could incur a substantial income tax bill.

But, by keeping the

property until death and not gifting, the farmer might expose the estate to the

Washington estate tax. Luckily for the farmer, Washington state provides relief

for the farmer from the Washington estate tax while still allowing the farm to

qualify for the federal step-up in tax basis.

The stereotypical

farmer is “land rich but cash poor.” The theory then is that it is burdensome

for family farms to pay the Washington state estate tax. At the same time

perhaps the Legislature wanted to provide an incentive for the retention of

family farms.

The relevant rules

are contained in RCW 83.100.046 as well as in the associated WAC 458-57-155.

Those two bodies of law lay out the precise rules that allow the farm deduction

and the stringent requirements that must be met. But, if the farm meets the

qualifications, then for purposes of determining the Washington taxable estate

(i.e. whether and to what extent the estate is subject to the Washington estate

tax), a deduction is allowed for the total value of the farm.

For example, assume

that Farmer A has an estate valued at $11 million, of which $10 million is the

value of the farm that meets all the requirements contained in both WAC

458-57-155 and RCW 83.100.46. Assume further that Farmer A passes away. Then

that estate would pay zero estate tax under federal law (as it is under the

current credit amount) and zero estate tax under the state of Washington estate

tax (even though it is about $9 million over the applicable exemption amount).

At the same time, the farmer’s farm is still entitled to the step up in tax basis. Accordingly, the farmer’s estate avoids the imposition of the estate tax while at the same time benefiting for a later reduction in income tax for his heirs. The family farm can produce benefits beyond its crops with thoughtful planning and utilization of current tax laws. It is important to note that not every farm and not every farmer will qualify for this generous deduction. As always, it is important to work with a qualified attorney and CPA to properly plan the best course of action for any individual estate plan.

Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick.